Chapter 1 – Introduction to international finance

Introduction to international finance

International Finance is an important part of financial economics. It mainly
discusses the issues related with monetary interactions of at least two or more
countries. International finance is concerned with subjects such as exchange rates
of currencies, monetary systems of the world, foreign direct investment (FDI), and
other important issues associated with international financial management.

Note − The World Bank, the International Finance Corporation (IFC), the
International Monetary Fund (IMF), and the National Bureau of Economic
Research (NBER) are some of the notable international finance organizations.

Meaning

International finance is the branch of financial economics broadly concerned

with monetary and macroeconomic interrelations between two or more
countries. International finance examines the dynamics of the global financial
system, international monetary systems, balance of payments, exchange
rates, foreign direct investment, and how these topics relate to international
trade.

Importance of International Finance

International finance plays a critical role in international trade and inter-
economy exchange of goods and services. It is important for a number of
reasons, the most notable ones are listed here −
 International finance is an important tool to find the exchange rates,
compare inflation rates, get an idea about investing in international debt
securities, ascertain the economic status of other countries and judge the
foreign markets.
 Exchange rates are very important in international finance, as they let us
determine the relative values of currencies. International finance helps in
calculating these rates.
  Various economic factors help in making international investment
decisions. Economic factors of economies help in determining whether or
not investors’ money is safe with foreign debt securities.
 Utilizing IFRS is an important factor for many stages of international
finance. Financial statements made by the countries that have adopted
IFRS are similar. It helps many countries to follow similar reporting
systems.
 IFRS system, which is a part of international finance, also helps in saving
money by following the rules of reporting on a single accounting standard.
 International finance has grown in stature due to globalization. It helps
understand the basics of all international organizations and keeps the
balance intact among them.
 An international finance system maintains peace among the nations.
Without a solid finance measure, all nations would work for their self-
interest. International finance helps in keeping that issue at bay.
 International finance organizations, such as IMF, the World Bank, etc.,
provide a mediators’ role in managing international finance disputes.
Functions
Corporate Financing Decision: Another important functions of international
finance is foremost decision is the amount of debt for a given level of equity. The
leverage and tax deductibility of Interest Payment and Debt would make the
company prefer as much debt as possible. But debt increases the risk and hence
there is a trade off between leverage and risk because of the debt risk.

Capital Structure: The Composition of Capital Structure influences the cost of

Capital and returns and thus the shareholders value. The composition of debt, its
currency, interest rate, maturity and other terms of debts, its currency, interest
rate maturity and other terms of debt are relevant valuables to be considered
Hedging of the debt risk reduces the risk of financial stress and even crisis.

Debt Crisis Effect on Banks The banks have become more cautious and started
lending only to countries with market oriented economies and undergoing
structural reforms. The development in International Debt market gave rise to the
new instruments and secondary market in many instruments such as scrutinized
debt. Debt repaying capacity and foreign exchange earnings and production use
of capital are all taken into account it is important functions of international
finance.

Methods of payment
The method of payment determines how payment is going to be made,ie the
obligations that rest with both buyer and seller in relation to monetary
settlement. In security order, the basic methods of payment could then be listed
as follows:

 cash in advance before delivery;

● letter of credit (L/C);
● documentary collection;
● bank transfer (based on open account trading terms);
● other payment or settlement procedures, such as barter or counter-trade.
Cash-in-Advance
With cash-in-advance payment terms, an exporter can avoid credit risk because
payment is received before the ownership of the goods is transferred. For
international sales, wire transfers and credit cards are the most commonly used
cash-in-advance options available to exporters. With the advancement of the
Internet, escrow services are becoming another cash-in-advance option for small
export transactions. However, requiring payment in advance is the least attractive
option for the buyer, because it creates unfavorable cash flow. Foreign buyers are
also concerned that the goods may not be sent if payment is made in advance.
Thus, exporters who insist on this payment method as their sole manner of doing
business may lose to competitors who offer more attractive payment terms.
Letters of Credit
The letter of credit (L/C) is a combination of a bank guarantee issued by a bank
upon the request of the buyer in favour of the seller (normally through an
advising bank) and a payment at sight or at a later stage against presentation of
documents which conform to specified terms and conditions.

It is estimated that up to 15 per cent of all international trade is based on Letter

of Credit, totalling over USD 1 trillion per year. The buyer establishes credit and
pays his or her bank to render this service. An LC is useful when reliable credit
information about a foreign buyer is difficult to obtain, but the exporter is
satisfied with the creditworthiness of the buyer’s foreign bank. An LC also
protects the buyer since no payment obligation arises until the goods have been
shipped as promised.

Other common forms of letters of credit

The transferable L/C can be transferred only when it relates to identical goods
and with the same terms and conditions as in the master L/C, with the exception
of amount, unit price, shipping period and expiry date – or any earlier date of
presentation – which may be reduced or curtailed. When later presenting the
documents under the master L/C, the seller is also allowed to exchange the
suppliers’ invoices for their own.

‘red clause letter of credit’ is used in inter-national trade, referring to a special

clause that can be inserted in the L/C. Through such a clause the seller can receive
an advance payment for part of the value of the L/C before presentation of
shipping documents (against a written confirmation of a later delivery), enabling
them to purchase raw material or to meet other costs prior to receiving full
payment upon presentation of conforming documents.

Documentary Collections
A documentary collection (D/C) is a transaction whereby the exporter entrusts the
collection of the payment for a sale to its bank (remitting bank), which sends the
documents that its buyer needs to the importer’s bank (collecting bank), with
instructions to release the documents to the buyer for payment. Funds are
received from the importer and remitted to the exporter through the banks
involved in the collection in exchange for those documents. D/Cs involve using a
draft that requires the importer to pay the face amount either at sight (document
against payment) or on a specified date (document against acceptance). The
collection letter gives instructions that specify the documents required for the
transfer of title to the goods. Although banks do act as facilitators for their clients,
D/Cs offer no verification process and limited recourse in the event of non-
payment. D/Cs are generally less expensive than LCs.
The general advantage with this method of payment is that the buyer knows that
the goods have been shipped and can examine the related documents before
payment or acceptance.
The first step in the collection procedure normally comes after shipment, when
the seller is preparing the documents which, together with their instructions, are
sent to their bank.
3. The bank checks the seller’s instructions and that they conform with the
enclosed documents. They are then sent to the collection bank chosen by the
buyer, together with the seller’s instructions.
4. The buyer is advised about the collection. Before payment/acceptance, they
have the right to inspect the documents – that they are all included as agreed
with the seller and that they appear to conform to the agreed terms. If so, the
buyer is expected to pay or accept the enclosed draft and receives the
documents.
5–6. Payment is transferred to the seller’s bank and thereafter to the seller as per
instructions. In the case of acceptance, the bill of exchange (the accepted draft)
is generally kept at the collection bank until maturity and is then presented for
payment as a ‘clean collection’, that is, without other documents.

Open Account
An open account transaction is a sale where the goods are shipped and delivered
before payment is due, which in international sales is typically in 30, 60 or 90
days. Obviously, this is one of the most advantageous options to the importer in
terms of cash flow and cost, but it is consequently one of the highest risk options
for an exporter. Because of intense competition in export markets, foreign buyers
often press exporters for open account terms since the extension of credit by the
seller to the buyer is more common abroad. Therefore, exporters who are
reluctant to extend credit may lose a sale to their competitors. Exporters can offer
competitive open account terms while substantially mitigating the risk of non-
payment by using one or more of the appropriate trade finance techniques
covered later in this Guide. When offering open account terms, the exporter can
seek extra protection using export credit insurance.

1. Invoice sent upon delivery.

2. Invoice payment in the bank, normally in local currency.
3. Bank transfer through the SWIFT system.
4. Payment in local or foreign currency, according to invoice and/or seller’s
instructions.

The SWIFT system

The SWIFT (Society for Worldwide Interbank Financial Telecommunication)
system, in which more than 10,000 financial institutions in more than 200
countries around the world participate. This network is cooperatively owned by
its members, which have created a low-cost, secure and very effective internal
communication system for both payments and messages.

SWIFT, bank transfers between countries and banks are now completed much
faster than before. When the instructions are fed into the system by the buyer’s
bank they are normally available at the seller’s chosen bank two banking days
later and usually available for the seller the next day or according to local
practice. Urgent SWIFT messages (express payments) are processed even faster,
but at a higher fee.

SWIFTNET
To enable banks and other financial institutions to offer risk management and
information services appropriate to today’s corporate supply chain, SWIFT has
developed different new messaging services over a standard platform called
SWIFTNET. This is basically a central trade data information-matching database,
which will provide both banks and their customers with a tool for monitoring the
chain of individual transactions, thereby increasing transparency and reducing the
uncertainty of the transaction.

Counter-trade
The word ‘counter-trade’ is in itself a general term representing various types of
connected transactions or reciprocal arrangements that are linked to each other
in a larger structure, necessary for the completion of the individual transactions.
The terms may vary, but the following are often used to describe the most
common forms of alternative trade transactions:

● barter trades – with payment in other goods;

● compensation trades – with payment partly in money but also in other goods
or services to balance the transaction, agreed between the parties;

● repurchase agreements – in which payment is made through products

generated by the equipment or goods delivered by the seller;
● offset counter-trades – mostly with settlement in money, but with the
transaction being dependent on corresponding sales/purchase transactions to
balance the payment flow.

International monetary system

The international monetary system refers to the operating system of the financial
environment, which consists of financial institutions, multinational corporations,
and investors. The international monetary system provides the institutional
framework for determining the rules and procedures for international payments,
determination of exchange rates, and movement of capital.

To operate successfully, it needs to inspire confidence, to provide sufficient

liquidity for fluctuating levels of trade, and to provide means by which global
imbalances can be corrected. The system can grow organically as the collective
result of numerous individual agreements between international economic
factors spread over several decades. Alternatively, it can arise from a single
architectural vision, as happened at Bretton Woods in 1944.

The major stages of the evolution of the international monetary system can be
categorized into the following stages.

1 The era of bimetallism - The exchange rates among currencies were determined
by their gold or silver contents. Some countries were either on a gold or a silver
standard.

2 Gold standard - The international gold standard prevailed from 1875 to 1914.
The exchange rate between two currencies was determined by their gold content.

3 Gold exchange standard - The Bretton Woods System was established after

World War II and was in existence during the period 1945-1972. Under this
system, the reserve currency country would aim to run a balance of
payments (BOPs) deficit to supply reserves. If such deficits turned out to be very
large then the reserve currency itself would witness crisis. 
4 Flexible exchange rate regime - flexible exchange rate regime was formally
ratified in 1976 by IMF members through the Jamaica Agreement. The agreement
stipulated that central banks of respective The countries could intervene in the
exchange markets to guard against unwarranted fluctuations.

The Bretton Woods Agreement, signed by the main industrial economies after the
Second World War, established a set of rules to regulate the international
monetary system with the intention of assuring monetary stability.  
TYPES OF EXCHANGE RATE REGIME
Within the flexible exchange rate regime there are 3 categories,

Floating

-Independent floating system

-Managed floating systems

Pegging

Target Zone Arrangements

FLOATING system

-Independent floating system does not involve intervention and so termed as

‘clean floating’.

-The purpose of intervention is simply to moderate the exchange rate and to

prevent any undue fluctuation.

-But no attempt is undertaken to achieve/maintain a particular rate.

MANAGED FLOATING SYSTEMS

Involves direct or indirect intervention by the monetary authorities of the country

to stabilize the exchange rate.

- Indirect intervention - The monetary authorities stabilize the exchange rate

through changing the interest rates.
-Direct intervention - The monetary authorities purchase and sell foreign currency
in the domestic market.

-Managed floating is also known as ‘dirty floating’

PEGGING

Periodic adjustment of fixed exchange rate to catch up with market determined

rates.

Combine the advantages of fixed exchange rate with flexibility of floating

exchange rate.

It fixes the exchange rate at a given level which is responsive to changes in market
conditions (i.e,) it is allowed to crawl pegging.

When exchange rate crosses limits, the monetary policies push the exchange rate
within the target zone.

If economic indicators are being disturbed, the monetary authorities let the
exchange rate depreciate or appreciate as the case may be.

TARGET – ZONE ARRANGEMENTS

Target zone arrangement involves member countries having fixed exchange rate
among their currencies. Alternatively, they may use a common currency.

FEATURES OF IMS
Flow of international trade
Investment according to comparative advantage
Stability in foreign exchange
Promoting Balance of Payments
Providing countries with sufficient liquidity

Plan for avoiding uncertainty

Allowing member countries to pursue independent

Monetary and fiscal policies

Chap 3 Changes in Capital Markets

The driving forces of financial globalization have led to four dramatic changes
in the structure of national and international capital markets.
 First, banking systems have been under a process of disintermediation.
Financial intermediation is happening more through tradable securities
and not through bank loans and deposits.
 Second, cross-border financing has increased. Investors are now trying to
enhance their returns by diversifying their portfolios internationally.
They are now seeking the best investment opportunities from around
the world.
 Third, the non-banking financial institutions are competing with banks in
national and international markets, decreasing the prices of financial
instruments. They are taking advantage of economies of scale.
 Fourth, banks have accessed a market beyond their traditional
businesses. It has enabled the banks to diversify their sources of income
and the risks.
Issues involved in international business and finance (contd..)